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IT Services: Q3FY18 Preview - Seasonally soft quarter, focus on commentary for CY18

Indian IT is expected to report a mixed quarter, given seasonal weakness. We expect the sector to report a US$ growth of 1%-2% QoQ for Q3FY18. INR is a marginal tailwind (+70bps QoQ) for the sector. Most of the cross-currency movement is stable QoQ with the exception of Australian Dollar (AUD). Adverse movement of AUD against the USD (2.7% QoQ) will likely impact USD growth for Infosys (INFO) and TCS to the extent of ~30bps. While margins will remain stable for the broader sector, Tech Mahindra (TechM) and Mindtree (MTCL) will see improvement in margins, in our view. Overall, we expect the sector to deliver INR Revenue/EBIT/PAT YoY growth of 9.0%/2.0%/0.8%, respectively. Margin recovery is the key theme for TechM and MTCL, and that will be the key driver for the share price performances of these companies in the near-term.  

Q3FY18 to reflect seasonality

December is a weak quarter impacted by furloughs and we expect similar seasonality to play out this quarter too. We expect Infosys/TCS/ HCL Technologies/Wipro to record sequential USD revenue growth of 0.9%/1.0%/1.9%/1.4%, respectively. TechM and Mindtree should see improved performance, as the drag from subsidiary performance abates, and we expect the companies to deliver QoQ USD revenue growth of 1.8% and 1.4%, respectively. We expect TechM and MTCL to see margin improvement of 119 bps and 116 bps QoQ, respectively. 

Guidance to remain in focus

Guidance from Infosys and HCL Technologies (HCLT) will remain in focus. This will be the first quarter for new CEO, Mr. Salil Parekh at Infosys and clarity on his strategy will be one of the key monitorables. We don’t expect Infosys to show any material shift from its current strategy. We estimate Infosys will maintain its FY18 USD revenue guidance of 6.5%-7.5%. On the other hand, there is likely to be tightening of the FY18 revenue guidance band (at the top end) from HCLT from 12%-14% to 12%-13%. We expect Wipro (WPRO) to guide to 2%-3% revenue growth for Q4FY18 with USD revenues of 2083-2104m.

Demand commentary, specifically US BFSI and Retail, key driver

While the quarter is likely to be mixed, all eyes will be on the demand outlook for CY18 by large players. US BFSI and Retail have been laggards for the sector, particularly for large caps (TCS/Infosys). A conducive US macro environment, industrialisation of new technologies and US tax reform can drive an uptick in tech spending. We have already seen solid numbers and commentary from Accenture, and we believe that commentary from large-cap players will be key monitorables this results season.

Maintain preference for TCS and Infosys among large caps

We continue to like the Indian IT space given our view, that valuations are cheap, expectations low and the sector is likely to see cyclical uptick from improved tech spending in the US. We maintain our preference for players leveraged to this cyclical spending uptick (TCS and Infosys). Within mid-caps, we like MTCL, considering the company’s strong positioning in new technologies and margin improvement, as headwinds abate and EPS growth recovers. Expect a steady quarter from MPHL and new deal wins will be key monitorable.